District Court Allows R&D Credit for Prototype Costs

By Gregory F. Homen, CPA, Los Angeles, CA, and Scott Vance, J.D., LL.M., Washington, DC

In a recent U.S. district court case, Trinity Industries Inc., No. 3:06-CV-0726-N (N.D. Tex. 1/29/10), the court held that the taxpayer (Trinity) is, in certain situations, entitled to the Sec. 41 research credit for qualified research expenditures (QREs) for activities relating to the design, development, and construction of new types/classes of ships. Trinity considered these first-in-class ships to be prototypes because the specific designs had never been previously attempted and, once validated and proven to meet their objectives, would be duplicated and commercially produced.


A division of Trinity, Trinity Marine Group (TMG), was in the business of shipbuilding. TMG incurred substantial expenditures developing first-in-class ships for various customers. The complexity of design ranged from new hull designs to mix-and-match combinations of existing components. Regardless of the type of design, none of the ships being developed had been constructed previously. These first-in-class ships were essentially prototypes developed to prove out a design. Trinity claimed the research credit for the QREs related to TMG’s first-in-class development efforts on its tax returns for the tax years ended March 31, 1994 and 1995 (when Trinity incurred the expenditures). The IRS disallowed the credit claims. Trinity argued that the claims were wrongfully disallowed, eventually bringing the dispute before the district court.

Because Trinity was not able to offer sufficient evidence for the court to determine QREs for a business component smaller than the entire vessel (Hurricane Katrina destroyed many of the records), Trinity adopted an all-or-nothing approach for each ship and applied the 80% threshold in Regs. Sec. 1.41-4(a)(6). Thus, Trinity would qualify for the research credit only if substantially all (80%) of the costs to build a first-in-class ship were QREs. Using this approach, the court found that of the six ships originally claimed by Trinity, only costs incurred for the development of two ships met the 80% “substantially all” threshold. Although the costs of the remaining four ships included qualified expenditures, the court was unable to apply the shrinking-back rule under Regs. Sec. 1.41-4(b)(2) to qualify any components of those ships because of the aforementioned lack of evidence of costs associated with any component subsets of the vessels. The court directed Trinity and the IRS to confer and work toward an agreement on the amount of remaining costs and the computation of the resulting research credits.

Application of the Law

Trinity and the IRS agreed that the costs of the ships met the statutory requirements, except for the business component and process of experimentation requirements. Under Sec. 41, for an activity to be qualified research, the research must meet four principal requirements:

  • The related expenditures may be treated as business expenses under Sec. 174;
  • The research is undertaken to discover information that is (1) technological in nature and (2) intended to be useful in the development of a new or improved business component;
  • Substantially all the activities constitute elements of a process of experimentation; and
  • The research is conducted for a permitted purpose (Sec. 41(d)(3)).

The court found in favor of Trinity and held that the costs incurred satisfied the business component and process of experimentation requirements.

Business Component: Held for Sale

The IRS argued that the ships did not constitute a valid business component because they were developed pursuant to customer contracts and not held for sale, as required by Sec. 41(d)(2)(B). The court disagreed with the IRS’s interpretation of the statute and found that before the developed vessels were conveyed to the customer, the construction was completed and the vessels were held for sale, meeting the definition of Sec. 41(d)(2)(B)(i).

Process of Experimentation: Existing Components

The IRS argued that many of the design activities involved integrating existing components rather than actually developing and experimenting with a new or improved product or process. The court again disagreed with the IRS, noting that existing components can interact adversely when used in different combinations or vessel designs. The simple fact that Trinity used existing components was not an indication of success, nor did it have any positive correlation to certainty.

The ship development at issue ranged from all-new designs to mix-and-match combinations of existing elements to slight modifications of existing designs. Instead of attempting to segregate these expenses, Trinity took an all-or-nothing approach to the litigation based on the substantially all rule discussed above. Trinity argued that because the design and construction of the ships were sufficiently experimental, the whole project constituted QREs. Thus, if Trinity could convince the court that 80% or more (substantially all) of the costs incurred were elements of a process of experimentation, the entire cost of the first-in-class ship development would qualify as a QRE (Regs. Sec. 1.41-4(a)(6)). At the same time, Trinity would stand or fall on this methodology; in the event that the company could not meet the substantially all rule, none of the costs would qualify.


While the parties will ultimately determine and agree upon the qualification, quantification, and final calculation of QREs and credits, the court directly and indirectly addressed some issues with positive implications for Trinity and other taxpayers.

Because the first-in-class ships are essentially developed as prototypes, the court appears to conclude that the costs of materials used in developing and constructing prototypes may be qualified. The court did not seem to condition its conclusions about the qualification of costs in the development/construction of a prototype on whether the prototype is successful and eventually turned into a salable product.

In addition, while the court found that certain subcontracting costs that the taxpayer incurred were mischaracterized as material cost, costs incurred in contracting/purchasing a prototype component from an outside contractor may qualify as a supply rather than be subject to the 65% contract research limitation prescribed by Sec. 41(b)(3)(A).

Similarly, if the risk of failure is applicable to a prototype on a project basis, when activities are substantially all qualified (80% or more) under Sec. 41, nonexperimental costs, such as paint, could be included in the total qualified cost of the prototype.

The court also accepted and applied the Cohan rule (Cohan, 39 F.2d 540 (2d Cir. 1930)) to establish qualified research through credible oral testimony. The qualification of activities, necessary to determine if a project met the substantially all rule, was based on testimony and exhibits provided by Trinity. (The Cohan rule was also applied in Union Carbide, T.C. Memo. 2009-50, and McFerrin, 570 F.3d 672 (5th Cir. 2009). For more on this issue, see Parshall, “Defending R&D Credits,” 41 The Tax Adviser 328 (May 2010).)

Editor: Mary Van Leuven, J.D., LL.M.


Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.

For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

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